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Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
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Proposed Corporate Tax Changes And Your Retirement Plan – Part I

September 19, 2017 - 3 comments

By now you have heard about the proposed tax changes that will affect Canadian business owners. You likely have an idea that these changes will affect your retirement. In this blog post I am going to quantify that effect.

The two biggest changes that will affect retirement planning are the elimination of what the government has labelled income sprinkling – the ability of business owners to extract dividends in the hands of family members, and the elimination of two tax mechanisms called CDA (capital dividend account) and RDTOH (refundable dividend tax on hand). I will address the effects of eliminating CDA and RDTOH in another post. Income sprinkling is an advantage to business owners because it allows them to pay income from their business to their lower income spouse and adult children. The result is that a business owner is able to use more of their business profits to cover personal expenses.

Let’s look at an example of an Ontario business owner who has received the advice to pay themselves dividends and retain all of their retirement savings inside of their corporation. Their spouse has never worked in the business. They have managed to accumulate $5,000,000 which they invest in a 60% equity – 40% fixed income portfolio. The portfolio has an expected return of 5.05%. They both turn 65 on January 1st, 2018 and will retire on that date. Neither of them will have any CPP due to a lifetime of taking dividends. They will take OAS at age 65, but most of it will be clawed back. Their retirement plan had always been to each take dividends to fund their $13,000 after-tax monthly spending goal, sharing the tax burden equally.

Under the current rules, when they are able to share the tax burden equally, they will each owe $17,734 at the end of 2018 between provincial tax and federal tax (including OAS claw back). Based on this, they can fund their lifestyle expense and personal tax bill with about $15,000 per month coming from the corporation. A $15,000 monthly draw from the corporate assets results in an 85% probability that the capital in the corporation will be sufficient to fund their expenses until death at age 95. They have built their retirement plan around this number.

  Business Owner Spouse Total
Ordinary Dividends 84,987 84,987 169,974
Eligible Dividends 4,383 4,383 8,766
OAS 6,364 6,364 12,728
Income 95,734 95,734 191,468
Federal Tax 12,504 12,504 25,008
Ontario Tax 5,230 5,230 10,460
Total Tax 17,734 17,734 35,468
After-tax income 78,000 78,000 156,000
Expenses 78,000 78,000 156,000

 

Under the proposed rules, the spouse will no longer be able to take dividends at their tax rate  – they will pay tax on dividends at the highest marginal rate. Due to this, the business owner will take all dividends themselves, using their own tax rates, and doubling the amount of income that they are paying tax on. They will now owe a total of $48,539 in taxes; an additional tax liability of just over $13,000 compared to when they were splitting the income with their spouse. As expected, this creates an after-tax income shortfall if they draw the planned $15,000 per month out of their corporation.

  Business Owner Spouse Total
Ordinary Dividends 169,974 - 169,974
Eligible Dividends 8,767 - 8,767
OAS 6,364 6,364 12,728
Income 185,105 6,364 191,469
Federal Tax 29,666 - 29,666
Ontario Tax 18,873 - 18,873
Total Tax 48,539 - 48,539
After-tax income 136,566 6,364 142,930
Expenses 78,000 78,000 156,000

 

To cover a $13,000 after-tax income shortfall, they will need to draw nearly $24,000 in additional dividends each year.

  Business Owner Spouse Total
Ordinary Dividends 193,615 - 193,615
Eligible Dividends 8,767 - 8,767
OAS 6,364 6,364 12,728
Income 208,746 6,364 215,110
Federal Tax 35,885 - 35,885
Ontario Tax 23,225 - 23,225
Total Tax 59,110 - 59,110
After-tax income 149,636 6,364 156,000
Expenses 78,000 78,000 156,000

 

This additional tax expense reduces the probability of them successfully funding their after-tax spending goal through retirement from 85% to 65%. To increase the probability of meeting their retirement income goals back to 85%, they will either need to retire four years later, at age 69, or they will need to find an additional $600,000 to invest inside of their corporation today.

The proposed elimination of income sprinkling has the potential to materially affect the retirement plans of anyone that had been counting on their corporate structure to reduce their tax bill through retirement. Of course, these are still proposals. As of now there is no action to be taken. In my next post, I will discuss the effects of eliminating CDA and RDTOH.

By: Ben Felix with 3 comments.
Comments
  26/09/2017 10:29:42 AM
Benjamin Felix
Hi Deidre,

Thanks for your question. My hope is not to change anyone’s mind – just to provide some objective analysis.

If we look at a teacher with an $80,000 per year pension at age 65, the average CPP amount of $644 per month, OAS of $584 per month, and a spouse with no pension or CPP, they would have an after-tax income of around $7,000 per month adjusted for inflation through retirement with no variability. They would be getting a huge benefit from the ability to split their pension income with their lower income spouse.

If we look at an incorporated individual with no CPP and a shareholder spouse to split income with, they would need to have about $2,000,000 in their corporation to cover an inflation adjusted $7,000 per month after-tax living expense with an 85% probability of not running out of money before age 95.

If income splitting for corporations is eliminated, the probability of the same couple not running out of money before age 95 drops to 50%. To get back to 85% they would either need to retire 6 years later, or save an additional $400,000 today.
 
  22/09/2017 5:06:22 PM
Mel Siu
Thank you so much for this article. It really helps when some examples with dollar amount is illustrated in your article.

I can't wait to read your next article about RDTOH as it affects me the most.
 
  20/09/2017 9:40:28 AM
Deidre Young
This is interesting but unlikely to change anyone's mind. There are a huge number of corporations that will not have anywhere near 5 million at retirement. How about an example that gives something comparable to a salaried professional pension for context. Such as DB plan for teacher or nurse at about 80K + COLA annually. What would this couple need now and what will they need with the changes.
 



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